Inequality causes recessions

“2021 Annual Economic Report,” Bank for International Settlements, June 2021, https://www.bis.org/publ/arpdf/ar2021e.pdf

While recessions tend to increase inequality, inequality, in turn, can intensify the depth and duration of recessions. As a result, recessions and inequality can reinforce each other over business cycle fluctuations. Aggregate demand shortfalls during downturns appear to be larger when the income distribution is more polarised, ie when the top earners account for a larger share of total income at the expense of the bottom earners. As noted above, low-income workers are typically the first to be laid off and hence see their incomes disproportionately curtailed. As much evidence confirms, the propensity to consume is higher for households with low income. Hence, if those at the bottom of the distribution lose their income in a downturn, a sharper contraction in aggregate consumption follows.

The evidence supports this view. All else equal, countries with higher income inequality appear to experience steeper declines in consumption during recessions (Graph II.7, left-hand panel).14 The pattern is also apparent across states in the United States. During the GFC, states with higher income inequality experienced significantly larger drops in consumption (right-hand panel). The variation in the share of income accruing to the top decile of the distribution across states accounts for more than a quarter of the variation in state-level consumption growth during the GFC. This is so even after filtering out the impact of the increases in state-level unemployment rates and declines in house prices.

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There is also evidence that financial recessions, even if they do not coincide with financial crises, are deeper and longer, and hence more costly in terms of inequality (Graph II.8). One way of seeing this is by considering recessions preceded by relatively high debt service ratios – a proxy for overindebtedness. The estimates suggest that eight quarters after the start of the recession, the average output drop is 2.5% larger and unemployment is 12% higher in financial recessions than in normal ones.

Inequality may not just amplify recessions; more subtly, it may also sow the seeds for them. For instance, it has been argued that higher inequality in the United States may have contributed to the build-up of housing debt. This was particularly the case for households with stagnating and less steady income, who were enticed into subprime borrowing. In turn, this higher leverage of households played a key amplifying role in the GFC, the archetypical “financial recession”. The reasoning is that low-income households have a larger need to borrow (eg to buy houses). If credit supply becomes more ample, this could encourage them to become overindebted. Down the road, an overburdened household sector can then trigger, or at least amplify, phases of weak economic activity. This impact is larger whenever the banking system comes under stress. Indeed, some observers have argued that this mechanism contributed to the subprime crisis that sparked off the GFC.15